After the Reserve Bank of India allowed them, middle and base layer non-bank lenders are looking at use cases for credit risk mitigation tools available to them.
“The whole spirit of these guidelines is that NBFC-ML and NBFC-BL will now be able to mitigate credit risk on their balance sheets and go for efficient allocation of capital,” according to Pankaj Naik, director, financial institutions at India Ratings & Research.
While the instructions in this regard are yet to be issued, the central bank’s idea behind this is to ‘harmonise’ the rules for all NBFCs, RBI Governor Shaktikanta Das said in a statement on Oct 6, after announcing the monetary policy committee's decision.
Credit Risk Mitigation Instruments - Explained
Under the scale based regulations of the RBI, NBFCs are classified into four layers –top, upper, middle and base– depending on their size, activity, and perceived riskiness.
In April 2022, the central bank had also announced the large exposures framework for upper layer lender, which allowed these entities to utilise such credit risk mitigation instruments.
"NBFCs face many risks related to liquidity, credit, interest rate, and even risk on collateral," according to Aalesh Avlani, co-founder and director of Credit Wise Capital, a base layer NBFC.
The idea behind this framework was to address the credit risk concentration in upper layer NBFCs by defining how to identify large exposures and refine criterias. It also put in place single counterparty and group of connected counterparty limits for lending by NBFCs.
Under the current guidelines, following CRM instruments are available for the upper layer:
Cash margin/caution money/security deposit - The right to set off is available with these and they are held as collateral against the advances.
Central government guaranteed claims - These attract 0% risk weight for capital computation
State government guaranteed claims - These attract 20% risk weight for capital computation
Certain corporate bonds hedged by credit default swap (CDS)
"There are many things that are done by NBFCs but they don’t get credit for that in the form of reduced risk weights. But with the extension of these tools to smaller NBFCs, they can now do a lot more," according to Vivek Iyer, partner-financial services risk advisory, Grant Thornton Bharat.
Capital Wins
With RBI's extension of CRM instruments to other NBFCs largely being a positive move, capital seems to be the biggest win, according to market participants.
Middle and base layer NBFCs will now be able to offset their exposures against the counterparty, which will help them in releasing more capital, according to Iyer.
"If more capital gets released, the NBFC can go and fund more to the sector they cater to; they can actually give more credit," he said.
This would also help NBFCs increase their assets under management quickly by allowing to remove the risk of exposure on one company and pass it on to a counter-party, according to Avlani.
As per the estimates by ICRA Ltd., the total AUM of NBFCs are expected to expand by 13-15% in FY24, backed by growth in NBFC-Retail at Rs 16.9 lakh crore and in NBFC-Infra at Rs 17.5 lakh crore. Overall AUM growth was 16% in FY23 and 9% in FY22.
"We can also continue expanding in the same sector without breaching the cap. In a way, it also starts a new lending line as earlier we were only raising capital from NBFC-UL. But now, we can approach other NBFCs too," Avlani added.
Sunil Lotke, chief legal and compliance officer of UGro Capital, a middle layer NBFC, agrees. "We’ll be able to transfer the exposure and the additional one can be given to group or single parties, only if they provide for capital release in guidelines. It will be great as it will help in deploying capital in the same sector and our AUM will grow," he said.
However, what CRM tools will be made available to the middle and base layer is yet to be announced by the RBI.
From a uniformity perspective, most tools, currently there for the upper layer, are expected be made available to others as well. But whether there will be additional tools, is what remains to be seen, market participants added.
"Cash margins and hedging may be allowed but we will have to wait and see," according to Iyer.
"We can't predict anything till proper guidelines come as the businesses of middle and base layers are very different. The tools may not be an exact replica but might have some tweaks," Lotke said.
The benefits to be derived from these CRM tools would also depend on the asset class NBFCs deal with, according to Rakesh Kumar, co-founder and CEO of Light, a middle Layer NBFC based in Ahmedabad.
"If you're dealing with high ticket loans, then credit risk mitigation tools will be very different. Tools like cash margin, securitisation etc., are for higher asset class. It is important to understand that sound underwriting and monitoring the borrowers credit worthiness are important for all NBFCs," he said.
Regardless of the type of CRM tools, NBFCs in the middle and base layer need to develop their capacity and learn about them for proper utilisation, Kumar added.
A lack of proper talent pool, familiar with these CRM tools, may be a challenge for smaller non-banks, according to Avlani.
"Usually upper layer NBFCs can afford such skilled people as they were the ones who had more exposures. But now, other NBFCs too need to prepare themselves to utilise the benefits from CRM tools," he added.
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